With the best interests of the investing public in mind, financial regulators have long sought to prevent retail investment in hedge funds and private equity. The Investment Company Act in the United States, for example, expressly forbids small investors from buying into such funds. And recent SEC overtures about dramatically raising the wealth threshold shows this desire is alive and well.

Obviously, investors want to invest in these funds. If they did not, regulation wouldn’t be required. So investors look for a “back door” entrance into the hedge fund club. Often, this comes in the form of simply buying the stock of a hedge fund manager itself. It may also come in the form of other publicly-traded entities. Or, it might come in the form of a foreign market for domestic funds.

An extensive new paper by Steven Davidoff of Wayne State University Law School refers to these investments as “black market capital” since they aim to side-step existing regulations. He says that black market capital is an “irrational” effect of SEC regulation since it actually causes small investors to invest in potentially “riskier and less suitable investments”.

Stock of Fund Advisers

Far from being victims of oppressive SEC regulations, it seems that owners of hedge fund IPO candidates may actually be the main beneficiaries of regulations preventing mass market investment in hedge funds and private equity. Says Davidoff:

“The success or failure of a fund adviser is therefore almost wholly dependent upon the fortunes of their underlying funds. But, unlike the funds themselves, these corporate advisers do not automatically come under the aegis of the Investment Company Act. Rather, since they are companies whose business happens to be advising hedge funds and private equity funds, they are treated under the federal securities laws as normal operating companies. Consequently, these advisers can publicly raise capital without triggering the Investment Company Act. Thus, they are a viable alternative for these fund managers to offer the public an opportunity to derivatively invest in hedge funds and private equity and share in the potential returns of these underlying investments.”

Davidoff says that Blackstone’s June 2007 IPO was oversubscribed mainly by investors who wouldn’t have qualified to actually invest in any of Blackstone funds themselves.